Ready for a Reboot? A Case of Consumer Déjà Vu

Viewpoints

With television studios redeveloping former hits like Will & Grace and The X-Files, you
could be forgiven for experiencing a case of déjà vu. For investors, these shows aren’t
the only thing that’s reminiscent of the 1990s. After several years of steady growth
and multiple expansion, the consumer staples sector is being re-rated by frustrated
investors after a slew of unimpressive earnings. Valuation compression in the sector
hasn’t been this extreme since 1999. While many assume this is a case of secular
headwinds, history suggests it is reflective of shifting risk preferences – and a signal
that cyclical pressure may be due for a reboot as well.

1990s as Analogue

The current operating environment for consumer staples resembles that of the late
1990s, and reflects three cyclical conditions: 1. Recovery-fueled growth, 2. Topline
pressure from vendor consolidation, and 3. Late-cycle margin compression from cost
inflation. This process mirrors what former Gillette CEO and industry icon James Kilts
termed the “Circle of Doom” in the early 2000s.

Growth: Despite having already reached maturity, the staples category experienced
a growth heyday in the early 1990s. Volumes generally grew in line to slightly
above global GDP (2%-4%), and the retail landscape was still regional in nature.
Supermarkets had not yet consolidated, discounters such as Wal-Mart had yet
to fully wade into the consumer products realm, and the club stores were still in
the growth stage. Consumer staples conglomerates wielded nationwide scale,
providing significant power in pricing negotiations.

Deceleration: Organic sales growth for the sector slowed from 7% in 1993 to
3% in 1999. Both price and volume headwinds were evident, as supermarkets
consolidated and big box concepts began to eclipse regional retailers. This new
channel spurred supply chain rationalization, eventually becoming the industry
pricing leader. The sheer length of the expansion was an issue too, as innovation
could not keep pace with a consumer leaning toward premium categories.

Cyclical Deceleration in Organic Growth for Consumer Staples

Source: Company Filings

While the rise of e-commerce in this cycle presents an entirely new distribution channel, the shift echoes the earlier era.
Initially, staples companies viewed e-commerce as more of a novelty, but underestimated the consumer penchant for an online
buying experience. This has led to pressure on volumes and price, as retailers have streamlined supply chains and increased
reliance on private label. Financially rehabilitated, consumers are trading up to premium products from familiar stalwarts in a
typical late cycle pattern.

Margin Pressure: Topline struggles in recent years are not the only corollary to the late 1990s. Rising input costs from
consolidation in the packaging space and an uptick in freight expense were margin headwinds in the late 1990s. If this sounds
familiar, it’s because nearly every consumer staples company blamed higher input costs and elevated freight rates for gross
margin compression in 1Q18.

Operating Margin Compressing From Cyclical Highs

Source: Bloomberg

The rising cost of freight looks poised to remain a headwind. This is primarily due to tightness in the trucking market, driven by
a shortage of drivers and regulatory changes. The industry was short 248,000 drivers at the end of 2017 according to data from
transportation consultant FTR, due to in part to low unemployment and competition from other industries (energy, construction,
etc.). Exacerbating this shortage is the new Electronic Logging Device Rule that took effect in 2017, which prevents drivers from
exceeding federal limits on hours.

Based on FTR’s 1Q18 commentary, freight costs are trending 10% to 15% higher for the year. Food manufacturer Treehouse
noted that freight costs increased by 12% in March, and that freight carrier acceptance – that is, the proportion of loads taken on
by transport partners – has declined by 25%. General Mills also stated that roughly 20% of shipping has occurred on a spot basis,
above the 5% historical average. Historically, consumer staples have been able to pass through costs with a lag averaging two to
three quarters, but given the structural changes afoot in retail, it is currently difficult to do so.

Tight conditions in the freight market matches up well with the trend of the late 1990s. The Cass Freight Indices have accelerated
dramatically, and this coincides with rising inflation. CPI remains in the 2% area, near the same levels observed in 1999.

Cass Freight Indices Accelerating Again

Source: Bloomberg

Valuation as Prologue?

The resemblance of current operational results to those of the late 1990s is notable, and the deterioration in investor sentiment is
similar as well. Valuation multiples for the consumer staples sector have exhibited significant compression in recent weeks. The
trailing EV/EBITDA multiple for the S&P Consumer Staples index has fallen from 14.9x at the end of January to 13.1x now, the
largest multiple (1.8x) and percentage declines (11%) since 2009. This decline is twice that of the S&P 500, and four times that
of the S&P Consumer Discretionary index – a degree of underperformance that hasn’t been seen since 1999. The fundamental
similarities between then and now – along with ebullience in technology – provide evidence that consumer staples may be
signaling the conclusion of this cycle.

As in 1999, Multiple Compression is Being Led by Staples

Source: Bloomberg

Hollywood studios will continue rebooting hits from the 1990s in the near future, with beloved films like The Lion King and Aladdin
expected to induce déjà vu for parents everywhere. We get that same eerie familiarity when looking at the recent declines in
consumer staples, and would submit that it is another example of late cycle behavior. Fortunately, the companies in this sector
boast resilient models that will outperform in downturns, even as the “safe” growth companies of today reach unanticipated
breaking points. Sector underperformance in 1999 proved to be an opportunity for the cycle-aware value investor, and we expect
recent weakness to provide a similar opportunity.